1.1 Telecommunications Economics and the Policy Case for Legal Monopolies
The telecom sector is defined as a network industry, i.e., an industry characterised by a collection of connected nodes, on both supply and demand sides. Services or goods are “delivered” among nodes to end-users: delivery connections are one-way directional in some network industry markets (e.g., natural gas, water, cable TV, broadcasting), while in others, such as phone and internet, connections are two-way directional.
A crucial economic feature of network industries, and telecom markets in particular, is network externalities, sometimes defined as demand-sided scale economies, due to which: (a) the overall value of a given network grows as users of the network increase, and (b) the marginal value that network users receive from their subscription grows as the number of reachable users increases.1
Networks could be either physical or virtual. Telecom networks, delivering services to consumers, are pervasive physical infrastructures.2 Building and managing a telecom network infrastructure require high fixed costs (i.e., costs not dependent on the level of service provision), which underly economies of scale, that is, a continuous decline of the long-run average costs of production as the quantity produced increases. Moreover, telecom production cost is also influenced by economy of density for the provision of services, where the average cost of production decreases as the density of customers increases. All these elements in turn imply that a single firm supplying the whole market demand has lower production costs compared to the overall costs that two or more producers would have.
At the early stages of the industry, this economic framework originally led to the natural monopoly argument, where, for purely technological reasons, a monopoly is more cost-efficient than multi-firm production. In a single-product industry, scale economies are a sufficient (but not necessary) condition to have a natural monopoly, whereas in a multi-product industry, such as telecommunications, the sufficient condition for a natural monopoly is given by the concept of sub-additivity. Applied to the cost function, this means that, regardless of which combination of desired outputs is chosen, it is cheaper for a single firm to produce that combination.3 This also implies the existence of economies of scope, another feature of the telecom industry and those sectors with multi-purpose networks, where multiple services can be provided simultaneously. Economies of scope entail the average total cost of production to decrease as a result of increasing the number of different services produced.4
Hence, the traditional thought was that “the presence of natural monopoly characteristics often means that competition cannot be relied upon to provide the socially optimal outcome, and some form of government intervention in these industries may be desirable.”5 In the next section, we will see how technological innovation led to a paradigmatic change regarding the natural monopoly argument in telecom markets, favouring the idea of multiple competing network operators. However, traditionally, the search for a solution to the economic problem of natural monopoly and to the political issue related to a pervasive provision of telecom services at affordable prices (universality of service) led policymakers to provide one single company with exclusive and special rights, i.e., a legal monopoly. The only company allowed to lawfully operate in the market was required to guarantee services to the entire population at fair and equitable prices. The legal monopoly situation took two alternative forms, not dependent on economic rationale, but rather on regulatory legacy and political reasons: (a) state-owned national monopolies, as occurred in almost all EU and OECD countries; (b) private (local) monopolies, subject to public regulation, as occurred in the US.
Regardless of the ownership and control of companies, all legal monopolists were responsible for both building and maintaining the network and for delivering the final service to customers, meaning that “natural monopolies in networks supported monopolies in services.”6 This value chain setting is defined as vertical integration and is further explained by another economic characteristic of the telecom sector: different market segments of telecom markets are characterised by complementarities, making vertical integration cost-efficient (and vertical separation subject to opportunity costs). However, end-to-end vertical integration was used by policy-makers also to extend the scope of reserved activities, in order to include additional profitable services and products, e.g., the legal monopolies on phone terminals and phone directories, which was void of any economic rationale. Moreover, end-to-end integration allowed complete control of the network and services by the state for reasons of national security (national interest argument).
Due to the economics of the sector and other political arguments, for many years the European telecom markets were indeed legally protected national monopolies, where only one vertically integrated company in each country could lawfully operate. Monopolistic market structures were also chosen based on the consideration that a free market would not have guaranteed the socially desired universality of service: it was (and still is) considered essential to provide basic communication services at an affordable price to all. In legal terms, communication services satisfy fundamental needs of customers and citizens, in order to pursue the constitutional principle of social inclusion. In economic terms, a universal service policy maximises the positive direct and indirect impact of telecom services on economic growth and development, and internalise their extensive positive externalities to the overall economy and society. As a matter of fact, many empirical analyses recognise a positive causal effect of telecom networks and services diffusion on GDP growth.7 This effect increases more than proportionally as networks and services penetration increase and become significant once a critical mass is reached. Critical mass appears sometime to be near universal service level.8
However, profitability in the telecom industry is differentiated according to the demographic (and geographic) characteristics of each area, also because of economies of density. There are therefore more profitable, less profitable and entirely unprofitable areas. Under a legal monopoly regime, the provision of service in unprofitable areas is financed by cross subsidies. Under a cross subsidies regime, monopoly gains in profitable areas, which are significantly higher than what they would be in a competitive market, compensate losses in unprofitable areas. Whereas, in a free or liberalised market, ne...